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March 28, 2006

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Sure, if you pick a careful variety. The problem is that is very difficult to do in in pharmaceutical companies.


Fidelity Select Pharmaceuticals Fund holds 113 different stocks. The portfolio has a beta of .74, indicating that the volatility is considerably less than that of the market as a whole. A separate fund, their Biotechnology Fund holds 91 stocks, with a beta of .92, again indicating less volatility than the market as a whole.

you are assuming constituents of A which don't make a fair comparison to B. Basically you are suggesting that you use one diversification model in creating B and a totally different model for creating A. If you use the same diversification model in both cases you won't get A riskier than B.

A fair complaint, to which I respond:

1. My original point was that portfolios are less risky than individual stocks, so judging the risks ofthe sector by looking at individual stocks is deceptive.

2. The difference in riskiness of A and B, given reasonable differences in the risk of the individual components, goes away pretty quickly as the portfolios get bigger.

...and then you have to consider what happens to profitability, when you aggregate stocks in that way. My guess: with diminishing risk comes diminishing upside return. Which is pretty much Sebastian's point from the start, I think.

The fund you reference outperformed the SP500 on a 1 year basis, underperformed on a 3 year basis, and was negative even in real terms on a lifetime basis. I also wonder which benchmark they used for beta (it isn't disclosed but isn't always the SP500).

.and then you have to consider what happens to profitability, when you aggregate stocks in that way. My guess: with diminishing risk comes diminishing upside return.

Bad guess. The general theoretical point is that with diversification you can reduce the risk needed to achieve a given level of expected return. You can buy on margin if you want to increase both risk and return.

The fund you reference outperformed the SP500 on a 1 year basis, underperformed on a 3 year basis, and was negative even in real terms on a lifetime basis. I also wonder which benchmark they used for beta (it isn't disclosed but isn't always the SP500).

The pharmaceutical fund did underperform the S&P over three years. Hardly surprising, given the low beta and an expense ratio in excess of 1%. The biotech fund actually has outperformed the S&P500 over ten years, despite a 1% expense ratio. This is an impressive performance, at least on the surface.

As for beta, they are not clear as to the benchmark, but it certainly should be a broad-based market index.

I think you are misusing beta in your analysis. R^2 (valued from 0-1)is the measure of fluctuations tied to the market. Beta is a pretty good indicator of volatility when R^2 is close to 1. For the one you mention it isn't at all close to 1, the R^2 value is 0.24. This can be seen in the standard deviation which is a very high 16.68--taken together this shows high volatility.

I am not misusing beta (except to the extent that there is disagreement about the validity of beta as a measure, but that is another matter).

The central notion is that beta measures market risk - the degree to which a stock or a portfolio moves in accordance with the market. That is the risk an investor ought to be concerned about. If you hold a diversified portfolio, and you should, the independent movements of the individual holdings will not affect your returns so much precisely because they are independent. It is correlated risks - in this case market risks - you have to worry about.

How much does buying Fidelity's pharmaceutical fund increase the risk of your portfolio? Not, how risky is the fund in isolation? That is the question beta tries to answer. The fact that the fund has a high standard deviation of returns is interesting, but is very far from the whole story.

(BTW, It's not clear what standard deviation they are citing. I would assume it is annual returns, but the one they give for an index fund is 8.87%, and my impression is that the S&P actually runs around 15%)

"The central notion is that beta measures market risk - the degree to which a stock or a portfolio moves in accordance with the market."

This is true with high R^2 values. This is not nearly as true with low R^2 values such as the fund you mention.

See for example this explanation at investopedia of volatility measures:

R-squared values range between 0 and 100, where 0 represents the least correlation and 100 represents full correlation. If a fund's beta has an R-squared value that is close to 100, the beta of the fund should be trusted. On the other hand, an R-squared value that is close to 0 indicates that the beta is not particularly useful because the fund is being compared against an inappropriate benchmark.

The R^2 value of the one you mention is (on the 100 point scale) is 24. This is very low. This makes sense because pharamaceutical profits are not closely correlated to general market conditions. The standard deviation on the one you mention is huge--and you can see the volatility on the graph they provide.

Whoops the link didn't make it for some reason.

http://www.investopedia.com/articles/mutualfund/03/072303.asp

Sebastian's right, Bernard: Beta's a measure of covariance, not variance.

Sebastian,
Thanks for your response and I see that you did discuss the SI&A question earlier, but I passed over that (I really don't do any investing at all) and in reading your 4:11am comment, I didn't take the 'let's go back to the data' as a reference to previous discussion. Apologies if it seemed like I was dragging up something that you may have felt you had already dispatched.

I am way over my head with this, but I'm a bit surprised that when I google things Pfizer + SI&A I get multiple links with that info, but when I google Merck + SI&A, I only get 41 hits, and the majority of them are from Pfizer reports that make mention of Vioxx. Also, in trying to look at the 10-k for Merck, I was surprised that for financial data, they simply referred to pages in the stockholder reports and the terms they use there are different (rather than SI&A, they use Marketing and Administration, and they don't have a Cost for Sales category) If anyone has any insight into this and wouldn't mind explaining it, I'd appreciate it.

My understanding is that some terms are standard and some aren't. If a company has been around for a long time (and assuming their terms aren't ridiculous) it is ususally considered better to maintain continuity over years rather than changing definitions. Better to allow direct year to year comparisons than to try to keep up with all the definitional trends. I presume at some point that can become a problem, but there you are.

Sebastian and USA,

It is true that beta does not measure all the risk of a stock. It tries to measure relevant risk. If the R^2 of the regression used to measure beta is low, that merely means the relevant portion is a small part of the total.

The risk of a security is divided into two components: "non-systematic," sometimes called idiosyncratic, risk, and "systematic" or market risk.

The former is the risk associated with the individual company (or fund or whatever). In the case of a pharma it includes, for example, the risks of its drug development projects. The critical idea is that the company stock responds to these risks independently of market moves.

This is not true of systematic risk. This is the risk to an investor that arises because the stock covaries with the market. This covariance exists for all sorts of reasons, general economic conditions, attitudes toward the market, imperfect information about individual companies, etc.

Beta is an attempt to measure this systematic risk. In statistical terms it is the regression coefficient you get by regressing the security's return on the excess of the market return over the risk-free return. (For this reason it is strange to read about the "wrong benchmark." In principle the benchmark is the market, the set of all risky assets. In practice the S&P500 is often used, but it shouldn't matter much, since any sensible proxy will correlate closely.)

Now, in principle, an investor is compensated with higher expected returns only for the systematic risk associated with a security. The idiosyncratic risk doesn't matter, precisely because it is idiosyncratic, hence it more or less "disappears" in a well-diversified portfolio. Thus systematic risk is what is relevant when considering compensation for risk.

This is not particularly intuitive. But what it captures - the point I've been trying to make - is that looking at the risk of an investment in isolation makes no sense. It must be examined in the context of a portfolio, and if your portfolio is not well-diversified then you are taking on more risk than you need to when you decide to buy some stock in Merck, for example.

Take a simple example. Suppose you have made a $10 bet on the toss of a coin. Heads you win, tails you lose. Call this coin M. Now you have a choice between two other $1 bets. You may make a similar bet on a coin, A, whose fall is perfectly correlated with M. A and M will always both come up heads or both come up tails.

Bet B is on a different coin, whose fall is independent of M. Further, the coin is weighted so as to come up heads only 25% of the time. To make the bet fair you receive a payoff of $3 for heads, while you lose only your $1 bet on a tails.

Both bets have zero expectation. Which is riskier? Taken in isolation it is clear that B is riskier. The outcome has a higher variance. But in combination with bet M, A is the riskier bet. The A + M combination has a higher variance than the B + M combination. Think of B as a low-beta, low R^2 stock, and you see why beta is the appropriate measure of risk for an investor, low R^2 or not.

"Now, in principle, an investor is compensated with higher expected returns only for the systematic risk associated with a security. The idiosyncratic risk doesn't matter, precisely because it is idiosyncratic, hence it more or less "disappears" in a well-diversified portfolio. Thus systematic risk is what is relevant when considering compensation for risk."

But you can't diversify around the idiosyncratic risk of JUST pharmaceuticals so easily because their risk is so high that adding just a few does not well-diversify your portfolio. Rmember that in this particular example you are seeing a low R^2 showing up in mutual funds not individual stock--which should already be somewhat diversified. This shows that the whole sector is pretty much independent of the market as a whole--which is what we would expect because they are so dependent on hit or miss miss miss miss miss miss miss research.

"Think of B as a low-beta, low R^2 stock, and you see why beta is the appropriate measure of risk for an investor, low R^2 or not."

It is if you have a choice between pharmaceuticals that are closely correlated with the market and those that aren't and you diversify between them. If pharmaceuticals as a whole are not closely correlated with the market and they have lots of losers compared to winners you can't so easily diversify just by adding a few more pharmaceutical companies. Proper diversification would lead you to invest in something more market correlated as well. But when talking about the riskiness of the sector you can't say that something with a low beta is low risk. It isn't. Your methodology would lead us to believe that pharma mutual funds are less risky than an SP500 index fund. They clearly aren't.

Now in theory if you invest in the whole pharma market you will do ok because the rate of return is high enough to compensate you for the risk. But the last part of that sentence is what saves you--and is exactly my point all along.

Your methodology would lead us to believe that pharma mutual funds are less risky than an SP500 index fund. They clearly aren't.

As an addition to a portfolio they may well be. In my coin example, consider B to be an investment in pharmaceuticals and A to be an investment perfectly matching the S&P.

I think you misunderstand what I mean when I say a "well-diversified portfolio." I do not mean a portfolio that just has lots of pharmaceuticals in it. I mean a broad portfolio with stocks form many industries, where pharmaceutical companies form only a small part.


I would also like to question your assumption that the total risk of pharmaceuticals is significantly higher than that of the market. I have been unable to find a clear comparison of total risks. Have you found one? After all, other companies have product development risks also.

"I think you misunderstand what I mean when I say a "well-diversified portfolio." I do not mean a portfolio that just has lots of pharmaceuticals in it. I mean a broad portfolio with stocks form many industries, where pharmaceutical companies form only a small part."

Sure, which is not relevant to the discussion of risk in the pharmaceutical sector. The fact that you can disversify all over the market to make up for the risk of the pharaceutical industry doesn't make the industry less risky. It is highly variable compared to many other potential investments.

Sure, which is not relevant to the discussion of risk in the pharmaceutical sector. The fact that you can disversify all over the market to make up for the risk of the pharaceutical industry doesn't make the industry less risky. It is highly variable compared to many other potential investments.

Actually, it's quite relevant, but I'm going to stop trying to convince you.

Instead, may I ask you for data comparing the riskiness of pharmaceutical companies to other types of firms, and to market indexes. I know you quoted some individual stocks, but that is hardly much in the way of support for your claim.

Sebastian: The fact that you can diversify all over the market to make up for the risk of the pharaceutical industry doesn't make the industry less risky.

It seems to me that, in the relevant sense, it actually does make the industry less risky. But then again I may be misreading you. Surely what's important here is whether the industry can raise funds on reasonable terms? If so then it doesn't matter that people who put all their eggs in one basket are taking a huge risk. Their money doesn't smell any sweeter than that of the big portfolio managers.

I presume that's Bernard's point (I'm taking the liberty of adopting his argument since he has given up trying to persuade you). What matters to a portfolio manager is whether a marginal increase in the industry's share of the portfolio improves the fund's overall risk-reward profile.

For my part, I'm not actually trying to convince you of this. My sense is that what's really bothering you is a different question, but you have got side-tracked. For example, there may be grounds for worry about talented individuals choosing careers elsewhere because "the system" doesn't offer them the right incentives. After all, a brainy individual can't just reduce his/her exposure to a career by making adjustments at the margin in the way a fund manager does.

But if what you're really worried about is the inability of the financial markets to price risk, I'm startled by your lack of faith in capitalism!

"But if what you're really worried about is the inability of the financial markets to price risk, I'm startled by your lack of faith in capitalism!"

I'm not worried about it under the present system. We seem to get new drugs funded by US market money on a very regular basis. I worry about what would happen if we dramatically decreased the money going in, or had the government try to dictate the investments rather than the market.

Kevin,

Your presumption is correct, and you expressed my point more succinctly than I was able to do. Thanks.

Fair enough. Not being American I don't have much to say about legal changes the industry may be facing, so I’ll bow out. There may be some merit in taking the discussion in the direction radish suggested a couple of days ago:

If you're arguing that the system in place is more or less appropriate and satisfactory then I wish you would say so in so many words for those of us who already acknowledge that drug development is a high risk venture. Especially if what you mean is that you're opposed to allowing any government entities to negotiate their purchase contracts with drug companies.

Have a good weekend.

Thanks Bernard. Judging by your comments I'd say you have a better feel for the practicalities of this than I do. I'm just regurgitating the contents of a a financial economics course from way back!

"The fact that you can diversify all over the market to make up for the risk of the pharaceutical industry doesn't make the industry less risky.

It seems to me that, in the relevant sense, it actually does make the industry less risky."

Huh? You are saying that you can diversify by investing into the market of everything done in the United States and that shows that the very limited subset of the pharma industry is less risky? How does that work? How does the fact that investing in all the companies in the US would let you diversify make investing in just the pharma companies less risky.

The point I present is that pharma companies (a limited subset of companies in the US) need to make greater returns than the market as a whole (the set of all companies in the US) because they are riskier. Your response appears to be that you can diversify into the market as a whole in order to reduce your risk. That is clearly true. You then say that fact somehow reduces the risk of the pharma companies. It clearly does no such thing. If you invest in pharma companies you are taking a greater risk than if you invest in the market (of all US companies) as a whole. If you diversify AWAY FROM pharma companies your risk clearly goes down--because pharma companies are riskier and because investing in the whole is almost always less risky than investing in a small subset. But that says almost nothing about the riskiness of the pharma group.

Sebastian: v. quick response as I'm away for the weekend. The crucial thing (if I'm right about what bothers you) is the cost of capital, particularly equity. That cost depends on expected return and on beta, but not on the variance of returns.

Breaking my resolution:

You are overlooking the distinction between systematic and non-systematic risk.

Also, to say that a pharmaceutical investor can diversify into the broader market is having the tail wag the dog. Pharmaceutical holdings are a part of a portfolio. Their risk should be evaluated in terms how it affects the portfolio risks, not in isolation.

Suppose you are in the business of providing fire insurance. You insure a house at 10 Main St. Now, all else equal, it is riskier to insure a second house at 12 Main than one across town. Even if all else is not equal, even if the one across town is, in isolation, a worse risk than 12 Main, it may still be less risky for you to insure.

There exist investors with well-diversified portfolios who are considering buying pharmaceutical stocks. To them the question is not the total risk of these companies, but how they affect portfolio risk. That is the risk they must be compensated for. Now, some investors may choose to hold only drug stocks,or otherwise be undiversified, and thereby subject themselves to the total risk involved, but they are betting - perhaps illegally, perhaps wisely, but probably foolishly - that market odds are way off.

Similar considerations apply, by the way, to arguments about how risky the drug development business is. The usual argument talks about research costs, failure rates, etc. Fair enough. But this needs to be put into context. If you have lots of projects, and the few winners are very lucrative, then the company's risk is not nearly so great as it would appear from looking at the odds on individual projects. It's the portfolio -there's that word again - of projects that matters.

"There exist investors with well-diversified portfolios who are considering buying pharmaceutical stocks. To them the question is not the total risk of these companies, but how they affect portfolio risk. That is the risk they must be compensated for."

No, if the risk of pharmaceutical stocks is greater than the risk of diversifying into OTHER areas THAT is the risk they must be compensated for.

If the price of a pharmaceutical stock is such that expected returns do not compensate for the risk, the price will fall until the stock is sufficiently attractive. In equilibrium, all the risk that can be eliminated by diversification (into any asset) is eliminated. So what's the problem?

"If the price of a pharmaceutical stock is such that expected returns do not compensate for the risk, the price will fall until the stock is sufficiently attractive."

Yes, and if the return routinely does not compensate for the risk people won't invest in it. That is precisely my point.

Sebastian,
You mentioned that this was a preliminary post and you were going to post something longer (about health care?), so I'm not sure why your above point requires a separate post. Was it just some commentors at Drum's site that made you write this, or do you have some specific legislation /action that should be taken or tabled in mind?

I have to admit, I'm baffled because it seems like you are arguing that companies that engage in risky business need to be additionally compensated in order to get them to do it, which contrasts with my impression that you were a free market kind of guy. Again, perhaps this is an outgrowth of comments made on another list, or I've totally misread you and you are sympathetic to government intervention, so apologies in advance if I've totally stuffed this up.

"I have to admit, I'm baffled because it seems like you are arguing that companies that engage in risky business need to be additionally compensated in order to get them to do it, which contrasts with my impression that you were a free market kind of guy."

The free market will give additional compensation--it does so now. It is government tampering that would try to keep that from happening.

It is government tampering that would try to keep that from happening.

Sebastian, I asked:

Was it just some commentors at Drum's site that made you write this, or do you have some specific legislation /action that should be taken or tabled in mind?

I guess I shouldn't have put that second section in, but I just wanted to try and explain where I was coming from. Sorry for not being very clear.

Yes, and if the return routinely does not compensate for the risk people won't invest in it. That is precisely my point.

If the return routinely falls short of expectations then expectations are so irrational that the market isn’t (even weak-form) efficient. As several of us have pointed out in different ways, you seem to have very little faith in markets. The conventional conservative argument goes something like this:

The income from stocks is inevitably volatile. Government intervention, which is generally clumsy, increases income volatility. Market participants adjust for this by demanding a higher average return. Since the price of the stock is just the present value of future income, the price falls until it hits the point where it yields the required rate of return. People won’t stop investing, but new stock issues will have to be cheap if they are to be taken up. So the industry’s cost of capital is higher than it need be and the growth of the industry is sub-optimal.

Now, that strikes me as a pretty good argument for leaving the rules of the game unchanged. We don’t have to be dyed-in-the-wool conservatives to agree that change entails significant transition costs. (It’s not a conclusive argument of course, because the existing rules may be so bad that the benefits of change outweigh the costs.) But you are not pushing that argument. You are pushing a decidedly non-conservative vision in which investors just can’t price risky assets so they run away from them instead: “if the return routinely does not compensate for the risk people won't invest in it”.

Frankly you have me baffled and – judging by the comments – most of your other readers also.

Sebastian,

This is not my area of expertise, so I have kept quiet and enjoyed the discussion from all participants. However, your comments suggest you may be going in a direction which I will feel uncomfortable with.

Let's assume that we can agree that pharmaceutical research is a riskier than typical business and therefore needs to have higher than expected returns to induce investors. This seems to jibe with my memory of finance classes over 2 decades ago.

The questions then I am seeing for your next post are:

1. how much higher should the returns be? I know that one can argue the markets should decide this, but pharmaceutical product development is not currently a situation where there is no governmental intervention in the markets. From providing funds for basic research to patent protection on the products, there is already heavy a governmental presence. Therefore, the question remains whether the profit margin which is present is too high, and what is the proper way to reduce it to better reflect the actual risk.

2. In light of many other developed countries using some version of governmental price controls on pharmaceutical products, whether by single payor plans or single purchaser plans, all of which reduce the profit margin, is it proper for American consumers to pay the bulk of this extra profit themselves?

Can we get a consensus that these are more interesting concepts to discuss than the (to me) dry finance discussion we have been having?

Lots here, and in my skimming I may have missed this point being addressed.

If I am a regular and major customer with a given supplier, I expect to be able to negotiate certain deals in my favour. Suppliers are notably amenable to the idea of a discount on unit cost if you're purchasing a million units of something. The ability of both parties in the transaction to negotiate prices is an essential part of a free market economy.

Is a law that restricts my ability as a buyer to negotiate discount rates with a seller really a good thing, from a free market point of view? I appreciate the seller quite fancying it, but I as a buyer either pay over-the-odds for my major purchase, or cannot buy as much widgetry with my available cash.

And in an instance where "the buyer" is "The American Taxpayer," it seems reasonable to suggest that such a law would not only be enshrining anti-market practices in law, but also be funnelling tax money to industry without industry doing anything to earn it. Corporate welfare, you could say.

So, while the maths and all this talk of stock is riveting, at least some of its relevance is negated in a world where the government has already interfered with free market mechanisms in favour of Pharma companies.

"And in an instance where "the buyer" is "The American Taxpayer," it seems reasonable to suggest that such a law would not only be enshrining anti-market practices in law, but also be funnelling tax money to industry without industry doing anything to earn it. Corporate welfare, you could say."

When the buyer can not only take away their own purchasing, but threaten to take away your entire ability to make money on the product by removing your patent you aren't really in the standard market transaction.

When the buyer can not only take away their own purchasing, but threaten to take away your entire ability to make money on the product by removing your patent you aren't really in the standard market transaction.

But the question is, taking the assumption that pharmaceutical companies need to make more revenue than other companies, why use such a anti-market measure as price fixing to subsidize them? The market isn't standard here - but that doesn't seem a good reason to replace the market mechanism with a system that allows the seller to set their own price.

One question on fixed pharmaceutical prices, from a foreigner - does the government subsidize the medicines at all, or does the fixed price go entirely to the consumer? If it goes entirely to the consumer, this strikes me as akin to a negative health insurance - not only do the sick have to pay for their own care, they have to subsidize the pharmaceutical companies. If the pharmaceutical companies are to be subsidized to maintain their viability, what is the reason for shifting this burden entirely to the sick?

IRL interfered, so I never responded properly, Sebastian. Apologies for that - it seems rather late in the thread to go into it extensively so I'll wait for your next post on the subject :)

I read a lot on Derek Lowes blog and he seems a reasonable guy who also sees the flaws in the industry and agrees in part with the viewpoints of he Marcia Angell and Merrill Goozner.

He just assumes (like you seem to do) that more profit would lead to more research - and I don't think that is true. I'd be willing pay in some shape or form for more research, I just don't think paying American prices is the answer.

I also don't feel bad about paying less than the Americans - you have no idea how often I have to pay lots more on things like software because I a not American :)

What made the discussion less clear for me is that you ALSO brought shares into it, not just marketprices of drugs. Share prices (and the role of share holders) are a seperate topic for me.

Just wanted to clear up why I had not replied though - will now try to read through my enourmous blogbacklog :)

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